The real cost of the Buffet BofA investment

Several times watching CNBC this morning they are editorializing that the 6% coupon Buffet will get on his preferred stock investment is “not cheap”. Fox News has a similar report see here:

This simply is not correct – the 6% rate is actually 350 basis basis points or more cheaper than where other BofA preferreds were trading in the market.  It is not the coupon that makes the deal expensive, it is the warrant component. What Buffet did with a preferred plus warrants is essentially a form of convertible security. Like any convertible offering the issuing company (BofA here) is paying less than it would if it issued straight preferred or debt. Also the Buffet preferred is perpetual giving it about the same sensitivity to interest rate risk as a 30 year bond, which increases the risk to the investor and why the yield would be higher than say on a 10 year note. BAC had some short term debt that was yielding 6%, so a 6% coupon on a perpetual preferred which is lower in the capital structure, has more sensitivity to interest rates and more credit risk because preferred payments are optional, debt payments are not – is not expensive here.

Buffet is getting warrants to purchase 700 million shares of stock at essentially no premium to where the stock closed Wednesday. A typical convertible would have a premium of 22-24%, meaning the stock would have to rise 22-24% before the equity kicker had any value. In Buffet’s case he starts participating on the first movement up. This is what makes the financing expensive, not the 6% coupon. BAC has January 2013 calls that are trading at around $2.50 when I looked today, obviously higher than they were before the deal. But it also tells you that Buffet’s warrants which have a ten year term, have to be worth no less than $ 3 -4 per share by implication. Given it is only a $7 stock, there is a limit to what people will pay for an option on it. But if you take the mid-point and call it $3.50 – it means Buffet’s warrant value is $2.45 billion – almost exactly half of the $5 billion he is putting in.

Now the 6% coupon is on the the whole $5 billion, so it is a $300 million income stream. But if the warrants are worth call it $2.5 billion – the preferred really is worth the other $2.5 billion. So a $300 million dividend on $2.5 billion is actually 12% – so the cost of the Buffet capital is 12% per annum – and that is high – but what makes it high is “equity kicker” via the warrants, not the 6% coupon in and of itself.





The rating agencies: A Monster of our own making

There is now much press about Standard and Poors downgrading the US long term debt ratings. While people fret about the implications of this, keep in mind the rating agencies particularly the largest ones which have an official designation know as Nationally Recognized Statistical Rating Organizations (NRSRO) are creations of Congress and the SEC.  They are important only to the extent the government has made them important.

One of the smaller ones Eagan-Jones has already downgraded the US below AAA, but you never even heard of it. Why? Because Eagan-Jones is smaller, has only been in business since 1995 and only became a NRSRO in Dec 2007. You can be a rating agency and not be an NRSRO as is Weiss which also downgraded the US below AAA before S&P did. Weiss uses a different scale than S&P so it really has no AAA, but Weiss downgraded the United States from its top rating to S&P’s equivalent of a BBB. Is an opinion from S&P any better than Eagan-Jones or Weiss? Not really and often S&P is less reliable having the conflict of interest of being paid by issuers that the other two don’t.  S&P is only important because we have institutionalized them and Moody’s and made them important – but their analysis is no better and often worse than other credit agencies or even credit analysts working for brokerage firms.

What does a credit rating represent anyway? It usually just represents the ability to make timely interest and principal payments. Aside from the debt ceiling skirmish, as the US prints its own money, it really cannot default.  While it may pay you in a currency that is worth less and less, ratings are not designed to capture that. The dollar has lost major relative value versus the Euro over the years and that never influenced S&P to change a rating.

You can have AAA rated securities that never default, but still lose most if not all of their value. In the 1990′s, Orange County, California went bankrupt when essentially it got a margin call on its AAA securities portfolio that had declined preceitposly is value. How did this happen? Orange County held AAA rated inverse floaters, whose interest rate moved in an opposite direction from market rates. When market rates went up the interest paid on its secuties went down, sometimes to zero, so they lost value in the market. Some municipal governments were sold mortgage IOs (interest only Strips) that were AAA as they were Fannie/Freddie backed, so if the interest was due it would be paid, but in an IO if the mortgage is prepaid, the holder is no longer entitled to any interest, so when there is a wave of mortgage prepayments, your IO value heads towards zero.

As a result of the subprime mortage debacle where Moody’s and S&P had rated subprime mortgage pools AAA that sometimes became worthless and which 93% of them were later downgraded to junk status – the entire notion of NRSRO should have gone out the door. The rating agencies became a crutch for investors not wanting to do their own credit work.  Believe it or not, the rating agecnies went almost untouched in Dodd-Frank the principal piece of legislation designed to prevent another 2008 blowup. 

One of the biggest problem with ratings is their use as triggers for collateral calls, put provisions in debt instruments or changes in interest rates. It was this type of trigger as a collateral call that caused the AIG breakdown and subsquent government bailout. AIG never would have a liquidity problem if the rating agencies had simply not changed their ratings, because AIG was forced to put up billions in collateral for the credit default swaps it had written if it were downgraded – that is what triggered its collapse. Such of use of credit ratings should be prohibited by law, it should be against public policy and hence any contracts written as such would be unenforceable on a going forward basis. This is singularly the most important financial reform that should have been made that wasn’t.

Back to soveringn ratings – S&P is now saying that France is a better credit than the United States. This despite its own numbers that show France going forward to having a higher debt to GDP than the US.  This despite that France cannot print its own currency as it is on the Euro and the France might find itself on the hook for the debt of Greece, Portugal, Italy and Spain – we are supposed to take S&P seriously. This is not to say the US is in great financial shape – it is not, but is France really better? Don’t most Western European countries face the same demographic time bomb as the United States with a growing elderly population that is living longer than requires support and not enough young people to support them?

By the way a decade ago S&P said that the soverign debt of Botswana was less risky than Japan – that is because Botswana had so little debt, never mind that Botswana was receiving financial aid from Japan at the time.